Emerging CME rival shaping up

First he reviewed past efforts to break the Chicago Mercantile Exchange and Chicago Board of Trade's lock on futures trading, then Paul Saltzman borrowed from an old recipe: He enlisted many of the world's premiere financial institutions as investors in a new electronic exchange, finalizing the deal shortly before many of the players left for holiday vacations.

"Having market-makers and participants effectively own and control the exchange is the magical ingredient that will be the leading force behind our success," Saltzman, chief executive of the new exchange and chief operating officer of eSpeed, its platform provider, said in a telephone interview on Friday from Europe.

His strategy hearkens back to an antique era when the same brokers frantically negotiating deals through hand signals doubled as an exchange's owners. That era ended when electronic trading transformed exchanges into publicly held companies where members and shareholders have conflicts of interest.

The new exchange, which is financed by the self-described "consortium of 12" that includes Bank of America, Citigroup, Credit Suisse, Deutsche Bank, Merrill Lynch and Chicago-based hedge fund Citadel Investment Group, seeks to turn back time with the same computer technology that emptied the trading pits.

"Essentially, it's a reflection of the fact that the big banks and exchanges have come into competition," said Benn Steil, director of international economics at the Council on Foreign Relations. "This sounds like a way for the banks to try to recall some of their power."

After the Merc and CBOT merged in July to form CME Group, investors propelled its stock past $710 a share. Extreme profitability and an appetite for further expansion sent the stock soaring, an indication to some of a burgeoning monopoly. Since the new exchange was announced on Dec. 21, CME stock sank more than $30.

"Ever since the U.S. Department of Justice approved the merger, it became self-evident that a market-based solution would be developed," Saltzman said. "You had a bunch of firms with an aligned set of interests."

Almost half a year into the merger, many traders have yet to realize major savings from promised economies of scale. They pay roughly the same level of fees as they did last year when the exchanges were separate, according to an October earnings report showing that contract volume and revenues from fees increased at similar rates.

The CME Group charged an average of 62 cents for each of the 798 million contracts it executed during this year's third quarter, just a penny less than in the same quarter in 2006. By narrowly shaving fees while handling 49 percent more contracts, the exchanges' joint quarterly net income grew by 67 percent over that same period to $235.8 million.

Tremors trigger action

One of the reasons for the burst in volume is algorithmic trading by hedge funds and investment banks, in which market tremors trigger an equation that buys or sells a contract.

A November analysis by the Tabb Group, a financial markets consultant, predicts that automated trading seemingly freed from human variables will constitute 90 percent of all trading strategies by 2010, up from roughly 50 percent now. However, electronic trading fees average 14 cents more than the open outcry system dating back to the 19th Century.

Saltzman said his motivations transcend fee reductions, but stem from the need to have "a viable, competitive, alternate liquidity pool."

As the platform provider, eSpeed will have a 25 percent stake in the new exchange. Saltzman declined to say how much money will be invested in the exchange, although he said he anticipates announcing additional partners and unspecified "new features" next year regardless of any countermoves by CME.

"This is not about the CME," he said. "This is about our new exchange. The CME is a very well-respected, well-established company that serves a very important role in the capital markets."

A CME Group spokesman said that average fees are trending down, noting customers also received "hundreds of millions of dollars in capital and margin efficiencies" from the 2004 decision by CBOT to use the Merc's clearing corporation.

The CME Group is pushing innovations that encroach on investment banks' territory. Shortly after finalizing the merger, it rolled out plans for an interest-rate swap product. Swaps are trades for the cash flows generated by an underlying asset. Large investment banks have historically dealt with swaps "over-the-counter," or outside of an exchange.

By introducing a swaps product, the CME Group would end the banks' exclusivity and provide a degree of transparency that would likely assist smaller traders, said Craig Pirrong, a finance professor at the University of Houston.

"The Wall Street houses' most profitable domain is OTC because they're not paying fees," Pirrong said. "Centralized clearing would reduce their benefits."